When it comes to financial planning for children, parents often focus on saving for college first.  While that’s an important goal, it’s not the only important consideration. There are several financial tools available to parents that can be used to create a well-balanced strategy in the short and long term.  Some risky, some flexible, and some powerful, this article will help you make sense of those tools and help you make an informed decision before you open an account or buy a policy.

As a parent, it’s natural for you to want the best for your children.  You probably want to save for them, protect them financially, and avoid costly mistakes along the way.  The Uniform Gifts to Minors Act accounts, term life insurance, and Custodial Roth IRAs are all tools (each providing a different purpose) that can help you achieve those financial goals.

UGMA Accounts (Uniform Gifts to Minors Act)

UGMA (Uniform Gifts to Minors Act) accounts are custodial investment accounts owned by a minor.  They are managed by the parent (or custodian) until the child reaches the age of majority (18 or 21, depending on state law). The assets irrevocably belong to the child – they are permanent gifts and cannot be taken away. 

Pros:

  • Simple to open
  • No contribution limits
  • Funds can be used for any purpose that benefits the child
  • Often used for reaching shorter-term goals.

Cons:

  • Parents lose control when the child turns 18 (or 21)
  • Can impact college financial aid – UGMA assets are assessed more heavily than assets owned by parents
  • “Kiddie tax rules” apply.  These rules were created to prevent parents from shifting investment income to children who are in lower tax brackets.
  • Not tax-advantaged like retirement accounts

Takeaways:

  • Make the most sense when contributing modest amounts
  • Allow children to learn how to invest responsibly
  • Especially useful if child isn’t planning on attending college
  • Parent must be comfortable with child eventually taking over account responsibility 

Term Life Insurance 

Term life insurance provides coverage for a specific time period (such as 20 or 30 years).  It’s a life insurance policy on the parent designed to replace his or her income if he or she passes away during the term.  These policies have no cash value.

Pros:

  • Often very affordable – Cost depends on age, health, term length, and coverage amount.   A healthy parent in his or her 30s can often expect to pay tens of dollars per month for coverage
  • Provides the stability of replacing lost income for housing, childcare, education, etc.  
  • Beneficial to separate insurance from investing

Cons:

  • Risk of underinsuring
  • Letting coverage lapse could be risky for dependent children
  • Often confused for an investment.

Takeaways:

  • Can be an important tool (along with investments) for diversifying your financial strategy.  
  • Must understand the risks of underinsuring and lapse of coverage.

Custodial Roth IRA 

The Custodial Roth IRA is a powerful, but commonly misunderstood, tool.  In essence, it’s a Roth IRA opened for a minor child.  It requires earned income (legitimate W2 or self-employment income).  Contributions are made with after-tax dollars, allowing qualified growth and withdrawals to be tax-free.

Pros:

  • Could result in tax-free compounding of interest for decades
  • No penalty for withdrawing contributions (excludes earnings)
  • Great tool for teaching financial literacy
  • No current tax liability
  • One of the best ways to give a child an early start on retirement investing  

Cons:

  • Must earn real income 
  • Yearly contribution limits
  • Requires record-keeping discipline
  • Like UGMA accounts, control transfers to the child at the age of 18 or 21.

Combining these Tools

It’s important to understand the strengths and weaknesses of each financial tool to make informed long-term decisions.   If something goes wrong, term life insurance can protect your family.  UGMA accounts provide flexibility, and Custodial Roth IRAs build long-term wealth.  No one-size-fits-all strategy works.  However, each of these tools can work in combination with each other to promote steady financial growth while mitigating risk.